UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2016 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period of to Registrant s telephone number, including area code: (217) 245-4111 Commission File Number 001-34821 Jacksonville Bancorp, Inc. (Exact name of registrant as specified in its charter) Maryland 36-4670835 (State or other jurisdiction of incorporation) (I.R.S. Employer Identification Number) 1211 West Morton Avenue Jacksonville, Illinois 62650 (Address of principal executive office) (Zip Code) Indicate by check whether issuer (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period the registrant was required to submit and post such filings). Yes No Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of accelerated filer, large accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act. Large Accelerated Filer Accelerated Filer Non-Accelerated Filer Smaller Reporting Company Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No As of August 1, 2016, there were 1,798,544 shares of the Registrant s common stock issued and outstanding.
JACKSONVILLE BANCORP, INC. FORM 10-Q June 30, 2016 TABLE OF CONTENTS PART I Item 1. FINANCIAL INFORMATION Financial Statements Page Condensed Consolidated Balance Sheets 1 Condensed Consolidated Statements of Income 2 Condensed Consolidated Statements of Comprehensive Income (Loss) 3 Condensed Consolidated Statement of Stockholders Equity 4 Condensed Consolidated Statements of Cash Flows 5 Notes to the Condensed Consolidated Financial Statements 7 Item 2. Management s Discussion and Analysis of Financial Condition and Results of Operations 39 Item 3. Quantitative and Qualitative Disclosures about Market Risk 54 Item 4 Controls and Procedures 56 PART II OTHER INFORMATION 57 Item 1. Legal Proceedings 57 Item 1.A. Risk Factors 57 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 57 Item 3. Defaults Upon Senior Securities 57 Item 4. Mine Safety Disclosures 58 Item 5. Other Information 58 Item 6. Exhibits 58 EXHIBITS Signatures 59 Section 302 Certifications Section 906 Certification XBRL Instance Document XBRL Taxonomy Extension Schema Document XBRL Taxonomy Calculation Linkbase Document XBRL Taxonomy Extension Definition Linkbase Document XBRL Taxonomy Label Linkbase Document XBRL Taxonomy Presentation Linkbase Document
PART I FINANCIAL INFORMATION
JACKSONVILLE BANCORP, INC. ITEM 1. FINANCIAL STATEMENTS CONDENSED CONSOLIDATED BALANCE SHEETS June 30, December 31, 2016 2015 ASSETS (Unaudited) Cash and cash equivalents $ 9,636,838 $ 4,103,432 Interest-earning time deposits in banks 2,486,000 2,724,000 Investment securities - available for sale 67,620,547 64,294,937 Mortgage-backed securities - available for sale 24,521,854 23,178,395 Federal Home Loan Bank stock 363,800 1,113,800 Other investment securities 59,134 62,223 Loans held for sale - net 80,481 539,000 Loans receivable - net of allowance for loan losses of $2,958,565 and $2,919,594 as of June 30, 2016 and December 31, 2015 188,950,575 193,039,879 Premises and equipment - net 4,569,997 4,728,157 Cash surrender value of life insurance 7,182,518 7,093,640 Accrued interest receivable 1,982,561 1,715,676 Goodwill 2,726,567 2,726,567 Capitalized mortgage servicing rights, net of valuation allowance of $41,247 and $47,354 as of June 30, 2016 and December 31, 2015 587,762 597,713 Real estate owned 220,000 330,981 Deferred income taxes 1,273,549 1,583,067 Other assets 725,860 811,007 Total Assets $ 312,988,043 $ 308,642,474 LIABILITIES AND STOCKHOLDERS' EQUITY Deposits $ 254,261,041 $ 239,281,930 Other borrowings 3,535,881 15,131,710 Advance payments by borrowers for taxes and insurance 1,172,034 990,917 Accrued interest payable 104,919 118,335 Deferred compensation payable 4,591,510 4,492,594 Income taxes payable 29,515 49,291 Dividends payable 179,831 1,934,834 Other liabilities 1,272,010 1,076,363 Total liabilities 265,146,741 263,075,974 Commitments and contingencies - - Preferred stock, $0.01 par value - authorized 10,000,000 shares; none issued and outstanding - - Common stock, $0.01 par value - authorized 25,000,000 shares; issued 1,798,314 shares as of June 30, 2016 and 1,791,513 shares as of December 31, 2015 17,983 17,915 Additional paid-in-capital 13,786,098 13,664,914 Retained earnings 32,567,999 31,305,040 Less: Unallocated ESOP shares (199,790) (211,710) Accumulated other comprehensive income 1,669,012 790,341 Total stockholders' equity 47,841,302 45,566,500 Total Liabilities and Stockholders' Equity $ 312,988,043 $ 308,642,474 See accompanying notes to the condensed consolidated financial statements. 1
JACKSONVILLE BANCORP, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME Three Months Ended Six Months Ended June 30, June 30, 2016 2015 2016 2015 (Unaudited) (Unaudited) INTEREST INCOME: Loans $ 2,302,183 $ 2,345,009 $ 4,630,961 $ 4,688,363 Investment securities 437,575 393,613 873,405 774,436 Mortgage-backed securities 96,881 114,006 227,184 286,373 Other 13,146 6,951 27,370 11,899 Total interest income 2,849,785 2,859,579 5,758,920 5,761,071 INTEREST EXPENSE: Deposits 244,181 288,148 486,032 597,075 Other borrowings 3,003 4,993 10,062 10,116 Total interest expense 247,184 293,141 496,094 607,191 NET INTEREST INCOME 2,602,601 2,566,438 5,262,826 5,153,880 PROVISION FOR LOAN LOSSES 30,000 35,000 60,000 65,000 NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 2,572,601 2,531,438 5,202,826 5,088,880 NON-INTEREST INCOME: Fiduciary activities 82,670 68,813 162,674 147,439 Commission income 286,240 400,676 634,806 708,789 Service charges on deposit accounts 173,212 169,294 340,399 325,730 Mortgage banking operations, net 58,002 52,588 83,274 95,528 Net realized gains on sales of available-for-sale securities 106,537 78,860 208,098 212,076 Loan servicing fees 83,589 85,481 168,115 172,961 ATM and bank card interchange income 174,758 162,889 335,403 315,628 Other 69,662 73,934 140,976 178,314 Total non-interest income 1,034,670 1,092,535 2,073,745 2,156,465 NON-INTEREST EXPENSE: Salaries and employee benefits 1,680,543 1,623,598 3,382,683 3,261,840 Occupancy and equipment 250,041 243,920 506,982 499,314 Data processing and telecommunications 146,746 141,718 283,359 289,365 Professional 50,769 50,873 106,605 96,610 Postage and office supplies 58,689 59,333 123,325 114,443 ATM and bank card expense 102,246 89,560 189,895 174,617 Other 274,999 251,429 503,745 568,503 Total non-interest expense 2,564,033 2,460,431 5,096,594 5,004,692 INCOME BEFORE INCOME TAXES 1,043,238 1,163,542 2,179,977 2,240,653 INCOME TAXES 277,732 327,139 587,093 617,993 NET INCOME $ 765,506 $ 836,403 $ 1,592,884 $ 1,622,660 - NET INCOME PER COMMON SHARE - BASIC $ 0.43 $ 0.47 $ 0.90 $ 0.91 NET INCOME PER COMMON SHARE - DILUTED $ 0.43 $ 0.47 $ 0.89 $ 0.91 DIVIDENDS DECLARED PER SHARE $ 0.10 $ 0.08 $ 0.20 $ 0.16 See accompanying notes to the condensed consolidated financial statements. 2
JACKSONVILLE BANCORP, INC. CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) See accompanying notes to condensed consolidated financial statements. Three Months Ended Six Months Ended June 30, June 30, 2016 2015 2016 2015 (Unaudited) (Unaudited) Net Income $ 765,506 $ 836,403 $ 1,592,884 $ 1,622,660 Other Comprehensive Income (Loss) Unrealized appreciation (depreciation) on available- for-sale securities, net of taxes of $365,437 and $(467,102) for the three months ended June 30, 2016 and 2015, respectively, and $523,401 and $(168,180) for the six months ended June 30, 2016 and 2015, respectively. 709,380 (906,729) 1,016,016 (326,468) Less: reclassification adjustment for realized gains included in net income, net of taxes of $36,222 and $26,813, for the three months ended June 30, 2016 and 2015, respectively. and $70,753 and $72,106 for the six months ended June 30, 2016 and 2015, respectively. 70,315 52,047 137,345 139,970 639,065 (958,776) 878,671 (466,438) Comprehensive Income (Loss) $ 1,404,571 $ (122,373) $ 2,471,555 $ 1,156,222 3
JACKSONVILLE BANCORP, INC. CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY Accumulated Additional Other Total Common Paid-in Retained Unallocated Comprehensive Stockholders' (Unaudited) Stock Capital Earnings ESOP Shares Income Equity BALANCE, DECEMBER 31, 2015 $ 17,915 $ 13,664,914 $ 31,305,040 $ (211,710) $ 790,341 $ 45,566,500 Net Income - - 1,592,884 - - 1,592,884 Other comprehensive income - - - - 878,671 878,671 Stock repurchases (45) (119,270) - - - (119,315) Exercise of stock options 113 173,536 - - - 173,649 Tax benefit of non-qualified options - 3,696 - - - 3,696 Vesting options expense - 44,711 - - - 44,711 Shares held by ESOP, committed to be released - 18,511-11,920-30,431 Dividends ($0.20 per share) - - (329,925) - - (329,925) BALANCE, JUNE 30, 2016 $ 17,983 $ 13,786,098 $ 32,567,999 $ (199,790) $ 1,669,012 $ 47,841,302 See accompanying notes to condensed consolidated financial statements. 4
JACKSONVILLE BANCORP, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Six Months Ended June 30, 2016 2015 (Unaudited) CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 1,592,884 $ 1,622,660 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation, amortization and accretion: Premises and equipment 190,835 192,926 Amortization of investment premiums and discounts, net 249,993 360,551 Accretion of loan discounts (259) (259) Net realized gains on sales of available-for-sale securities (208,098) (212,076) Provision for loan losses 60,000 65,000 Mortgage banking operations, net (83,274) (95,528) Gain on sale of real estate owned (59,609) (7,607) Shares held by ESOP commited to be released 30,431 26,415 Tax benefit related to stock options exercised 3,696 4,138 Stock option compensation expense 44,711 44,711 Changes in income taxes payable (19,776) (299,055) Changes in assets and liabilities (124,711) (5,999) Net cash provided by operations before loan sales 1,676,823 1,695,877 Origination of loans for sale to secondary market (6,434,650) (8,652,121) Proceeds from sales of loans to secondary market 6,984,075 8,754,154 Net cash provided by operating activities 2,226,248 1,797,910 CASH FLOWS FROM INVESTING ACTIVITIES: Net change in interest-earning time deposits 238,000 (1,974,000) Purchases of investment and mortgage-backed securities (32,416,045) (17,594,920) Maturity or call of investment securities available-for-sale 4,600,000 1,000,000 Sale of investment securities available-for-sale 21,630,529 19,675,553 Sale of Federal Home Loan Bank stock 750,000 - Principal payments on mortgage-backed and investment securities 2,808,961 3,173,649 Proceeds from sale of real estate owned 149,202 47,085 Net change in loans 4,045,382 (377,948) Additions to premises and equipment (32,675) (59,099) Net cash provided by investing activities 1,773,354 3,890,320 (Continued) 5
JACKSONVILLE BANCORP, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW Six Months Ended June 30, 2016 2015 (Unaudited) CASH FLOWS FROM FINANCING ACTIVITIES: Net change in deposits $ 14,979,111 $ (7,417,691) Net change in other borrowings (11,595,830) 727,058 Increase in advance payments by borrowers for taxes and insurance 181,117 66,257 Exercise of stock options 173,649 261,364 Stock repurchases (119,315) (624,038) Dividends paid - common stock (2,084,928) (282,803) Net cash provided by (used in) financing activities 1,533,804 (7,269,853) NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 5,533,406 (1,581,623) CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 4,103,432 9,611,638 CASH AND CASH EQUIVALENTS, END OF PERIOD $ 9,636,838 $ 8,030,015 ADDITIONAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for: Interest on deposits $ 497,923 $ 619,983 Interest on other borrowings 11,587 10,179 Income taxes paid 750,000 916,000 NONCASH INVESTING AND FINANCING ACTIVITIES: Real estate acquired in settlement of loans $ 114,400 $ 180,325 Loans to facilitate sales of real estate owned 127,900 - See accompanying notes to condensed consolidated financial statements. 6
JACKSONVILLE BANCORP, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. FINANCIAL STATEMENTS The accompanying interim condensed consolidated financial statements include the accounts of Jacksonville Bancorp, Inc. and its wholly-owned subsidiary, Jacksonville Savings Bank (the Bank ) and its wholly-owned subsidiary, Financial Resources Group, Inc. (collectively, the Company ). All significant intercompany accounts and transactions have been eliminated. In the opinion of management, the preceding unaudited condensed consolidated financial statements contain all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the financial condition of the Company as of June 30, 2016 and the results of its operations for the three and six month periods ended June 30, 2016 and 2015. The results of operations for the three and six month periods are not necessarily indicative of the results which may be expected for the entire year, or any other interim period. The condensed consolidated balance sheet of the Company as of December 31, 2015 has been derived from the audited consolidated balance sheet of the Company as of that date. Certain information and note disclosures normally included in the Company s annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company for the year ended December 31, 2015 filed as an exhibit to the Company s Form 10-K filed in March 2016. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (GAAP) and to prevailing practices within the industry. Certain amounts included in the 2015 consolidated statements have been reclassified to conform to the 2016 presentation. 2. NEW ACCOUNTING PRONOUNCEMENTS In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). The update provides a five-step revenue recognition model for all revenue arising from contracts with customers and affects all entities that enter into contracts to provide goods or services to their customers (unless the contracts are included in the scope of other standards). The guidance requires an entity to recognize the revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. For public entities, the guidance is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, and must be applied either retrospectively or using the modified retrospective approach. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606) Deferral of the Effective Date, which provides a one-year deferral of ASU 2014-09. Management is evaluating the new guidance, but does not expect the adoption of this guidance to have a material impact on the Company s consolidated financial statements. Early adoption would be permitted, but not before the original public entity effective date. In April 2015, the FASB issued ASU No. 2015-05, Customer s Accounting for Fees Paid in a Cloud Computing Arrangement. This ASU provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing agreement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The new guidance does not change the accounting for a customer s accounting for service contracts. ASU No. 2015-05 is effective for interim and annual reporting periods beginning after December 15, 2015. The Company s current method of accounting for fees paid in a cloud computing arrangement is consistent with the accounting guidance provided by ASU No. 2015-05. Therefore, the adoption of ASU No. 2015-05 did not have a material impact on the Company s consolidated financial statements. 7
In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 is intended to enhance the reporting model for financial instruments to provide users of financial statements with more decision-useful information. ASU 2016-01 is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Adoption by the Company is not expected to have a material impact on the consolidated financial statements and related disclosures. In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The ASU requires an organization to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. Additionally, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. For public companies, this update will be effective for interim and annual periods beginning after December 15, 2019. The Company has not yet determined the impact the adoption of ASU 2016-13 will have on the consolidated financial statements. 3. EARNINGS PER SHARE Earnings Per Share - Basic earnings per share is determined by dividing net income for the period by the weighted average number of common shares. Diluted earnings per share considers the potential effects of the exercise of the outstanding stock options under the Company s stock option plans. Average shares outstanding exclude unallocated employee stock ownership plan (ESOP) shares. 8
The following reflects earnings per share calculations for basic and diluted methods: Three Months Ended Six Months Ended June 30, June 30, 2016 2015 2016 2015 Net income available to common shareholders $ 765,506 $ 836,403 $ 1,592,884 $ 1,622,660 Basic average shares outstanding 1,775,726 1,774,375 1,773,321 1,774,828 Diluted potential common shares: Stock option equivalents 16,458 14,442 15,044 13,618 Diluted average shares outstanding 1,792,184 1,788,817 1,788,365 1,788,446 Basic earnings per share $ 0.43 $ 0.47 $ 0.90 $ 0.91 Diluted earnings per share $ 0.43 $ 0.47 $ 0.89 $ 0.91 4. STOCK BASED COMPENSATION In connection with our 2010 second step conversion and related stock offering, the ESOP purchased an additional 41,614 shares for the exclusive benefit of eligible employees. The ESOP borrowed funds from the Company in an amount sufficient to purchase the 41,614 shares (approximately 4% of the common stock issued in the offering). The loan is secured by the shares purchased and will be repaid by the ESOP with funds from contributions made by the Bank and dividends received by the ESOP, with funds from any contributions on ESOP assets. Contributions will be applied to repay interest on the loan first, and the remainder will be applied to principal. The loan is expected to be repaid over a period of up to 20 years. Shares purchased with the loan proceeds are held in a suspense account for allocation among participants as the loan is repaid. Contributions to the ESOP and shares released from the suspense account are allocated among participants in proportion to their compensation, relative to total compensation of all active participants. Participants will vest on a pro-rata basis and reach 100% vesting in the accrued benefits under the ESOP after six years. Vesting is accelerated upon retirement, death, or disability of the participant or a change in control of the Bank. Forfeitures will be reallocated to remaining plan participants. Benefits may be payable upon retirement, death, disability, separation from service, or termination of the ESOP. Since the Bank s annual contributions are discretionary, benefits payable under the ESOP cannot be estimated. The Company is accounting for its ESOP in accordance with ASC Topic 718, Employers Accounting for Employee Stock Ownership Plans. Accordingly, the debt of the ESOP is eliminated in consolidation and the shares pledged as collateral are reported as unearned ESOP shares in the consolidated balance sheet. Contributions to the ESOP shall be sufficient to pay principal and interest currently due under the loan agreement. As shares are committed to be released from the collateral, the Company reports compensation expense equal to the average market price of the shares for the respective period, and the shares become outstanding for earnings per share computations. Dividends, if any, on unallocated shares are recorded as a reduction of debt and accrued interest. 9
A summary of ESOP shares at June 30, 2016 and 2015 is shown below. June 30, 2016 June 30, 2015 Unearned shares 18,787 23,845 Shares committed for release 1,192 1,146 Allocated shares 61,659 55,919 Total ESOP shares 81,638 80,910 Fair value of unearned shares $ 544,228 $ 562,027 On April 24, 2012, our shareholders approved the 2012 Stock Option Plan. On this same date, the compensation committee of the board of directors approved the awards of 104,035 options to purchase Company common stock. The stock options vest over a five-year period and expire ten years after issuance. Apart from the vesting schedule, there are no performance-based conditions or any other material conditions applicable to the options issued. The following table summarizes stock option activity for the six months ended June 30, 2016. Outstanding, December 31, 2015 61,120 $ 15.65 Granted - - Exercised (11,332) 15.65 Forfeited - - Weighted Weighted Average Average Remaining Aggregate Exercise Contractual Instrinsic Options Price/Share Life (in years) Value Outstanding, June 30, 2016 49,788 $ 15.65 5.75 $ 577,043 Exercisable, June 30, 2016 27,853 $ 15.65 5.75 $ 322,816 Intrinsic value for stock options is defined as the difference between the current market value and the exercise price. The value is based upon a closing price of $27.24 per share on June 30, 2016. 10
5. LOAN PORTFOLIO COMPOSITION At June 30, 2016 and December 31, 2015, the composition of the Company s loan portfolio is shown below. June 30, 2016 December 31, 2015 Amount Percent Amount Percent Real estate loans: One-to-four family residential $ 45,994,916 24.4% $ 47,395,344 24.6% Commercial 40,409,491 21.4 40,381,680 20.9 Agricultural 41,126,629 21.8 41,223,190 21.3 Home equity 11,203,055 5.9 11,691,545 6.1 Total real estate loans 138,734,091 73.5 140,691,759 72.9 Commercial loans 25,747,471 13.6 25,453,058 13.2 Agricultural loans 13,424,032 7.1 16,102,856 8.3 Consumer loans 14,021,513 7.4 13,741,093 7.1 Total loans receivable 191,927,107 101.6 195,988,766 101.5 Less: Net deferred loan fees 17,967 0.0 29,293 0.0 Allowance for loan losses 2,958,565 1.6 2,919,594 1.5 Total loans receivable, net $ 188,950,575 100.0% $ 193,039,879 100.0% The Company believes that originating or purchasing sound loans are a necessary and desirable means of employing funds available for investment. Recognizing the Company s obligations to its depositors and to the communities it serves, authorized personnel are expected to seek to develop and make sound, profitable loans that resources permit and that opportunity affords. The Company maintains lending policies and procedures designed to focus lending efforts on the types, locations, and duration of loans most appropriate for the business model and markets. The Company s principal lending activities include the origination of one-to four-family residential mortgage loans, multi-family loans, commercial real estate loans, agricultural loans, home equity lines of credits, commercial business loans, and consumer loans. The primary lending market includes the Illinois counties of Morgan, Macoupin and Montgomery. Generally, loans are collateralized by assets, primarily real estate, of the borrowers and guaranteed by individuals. The loans are expected to be repaid from cash flows of the borrowers or from proceeds from the sale of selected assets of the borrowers. Loan originations are derived from a number of sources such as real estate broker referrals, existing customers, builders, attorneys and walk-in customers. Upon receipt of a loan application, a credit report is obtained to verify specific information relating to the applicant s employment, income, and credit standing. In the case of a real estate loan, an appraisal of the real estate intended to secure the proposed loan is undertaken by an independent appraiser approved by the Company. A loan application file is first reviewed by a loan officer in the loan department who checks applications for accuracy and completeness, and verifies the information provided. The financial resources of the borrower and the borrower s credit history, as well as the collateral securing the loan, are considered an integral part of each risk evaluation prior to approval. The board of directors has established individual lending authorities for each loan officer by loan type. Loans over an individual officer s lending limit must be approved by the officers loan committee consisting of the chairman of the board, president, chief lending officer and all lending officers, which meets three times a week, and has lending authority up to $750,000 depending on the type of loan. Loans to borrowers with an aggregate principal balance over this limit, up to $1.0 million, must be approved by the directors loan committee, which meets weekly and consists of the chairman of the board, president, senior vice president, chief lending officer and at least two outside directors, plus all lending officers as non-voting members. The board of directors approves all loans to borrowers with an aggregate principal balance over $1.0 million. The board of directors ratifies all loans that are originated. Once the loan is approved, the applicant is informed and a closing date is scheduled. Loan commitments are typically funded within 30 days. 11
If the loan is approved, the borrower must provide proof of fire and casualty insurance on the property serving as collateral which insurance must be maintained during the full term of the loan; flood insurance is required in certain instances. Title insurance or an attorney s opinion based on a title search of the property is generally required on loans secured by real property. One-to-Four Family Mortgage Loans - Historically, the Bank s primary lending origination activity has been one-to-four family, owner-occupied, residential mortgage loans secured by property located in the Company s market area. The Company generates loans through marketing efforts, existing customers and referrals, real estate brokers, builders and local businesses. Generally, one-to-four family loan originations are limited to the financing of loans secured by properties located within the Company s market area. Fixed rate one-to-four family residential mortgage loans are generally conforming loans, underwritten according to secondary market guidelines. The Company generally originates both fixed and adjustable rate mortgage loans in amounts up to the maximum conforming loan limits established by the Federal Housing Finance Agency. The Company originates for resale to Freddie Mac and the Federal Home Loan Bank fixed-rate one-to-four family residential mortgage loans with terms of 15 years or more. The fixed-rate mortgage loans amortize monthly with principal and interest due each month. Residential real estate loans often remain outstanding for significantly shorter periods than their contractual terms because borrowers may refinance or prepay loans at their option. The Company offers fixed-rate one-to-four family residential mortgage loans with terms of up to 30 years without prepayment penalty. The Company currently offers adjustable-rate mortgage loans for terms ranging up to 30 years. They generally offer adjustable-rate mortgage loans that adjust between one and five years on the anniversary date of origination. Interest rate adjustments are up to two hundred basis points per year, with a cap of up to six hundred basis points on interest rate increases over the life of the loan. In a rising interest rate environment, such rate limitations may prevent adjustable-rate mortgage loans from repricing to market interest rates, which would have an adverse effect on net interest income. In the low interest rate environment that has existed over the past five years, the adjustable-rate portfolio has repriced downward resulting in lower interest income from this portion of the loan portfolio. In addition, during this period borrowers have shown a preference for fixed-rate loans. The Company has used different interest indices for adjustable-rate mortgage loans in the past such as the average yield on U.S. Treasury securities, adjusted to a constant maturity of one year, three years or five years. The origination of fixed-rate mortgage loans versus adjustable-rate mortgage loans is monitored on an ongoing basis and is affected significantly by the level of market interest rates, customer preference, interest rate risk position and competitors loan products. Adjustable-rate mortgage loans make the loan portfolio more interest rate sensitive and provide an alternative for those borrowers who meet the underwriting criteria, but are unable to qualify for a fixed-rate mortgage. However, as the interest income earned on adjustable-rate mortgage loans varies with prevailing interest rates, such loans do not offer predictable cash flows in the same manner as long-term, fixed-rate loans. Adjustable-rate mortgage loans carry increased credit risk associated with potentially higher monthly payments by borrowers as general market interest rates increase. During periods of rising interest rates the risk of delinquencies and defaults on adjustable-rate mortgage loans increases due to the upward adjustment of interest costs to the borrower, which may result in increased loan losses. 12
Residential first mortgage loans customarily include due-on-sale clauses, which gives the Company the right to declare a loan immediately due and payable in the event that, among other things, the borrower sells or otherwise disposes of the underlying real property serving as collateral for the loan. Due-on-sale clauses are a means of imposing assumption fees and increasing the interest rate on the mortgage portfolio during periods of rising interest rates. When underwriting residential real estate loans, the Company reviews and verifies each loan applicant s income and credit history. Management believes that stability of income and past credit history are integral parts in the underwriting process. Generally, the applicant s total monthly mortgage payment, including all escrow amounts, is limited to 28% of the applicant s total monthly income. In addition, total monthly obligations of the applicant, including mortgage payments, generally should not exceed 38% of total monthly income. Written appraisals are generally required on real estate property offered to secure an applicant s loan. For one-to-four family real estate loans with loan to value ratios of over 80%, private mortgage insurance is generally required. Fire and casualty insurance is also required on all properties securing real estate loans. Title insurance, or an attorney s title opinion, may be required, as circumstances warrant. The Company does not offer an interest only mortgage loan product on one-to-four family residential properties (where the borrower pays interest for an initial period, after which the loan converts to a fully amortizing loan). They also do not offer loans that provide for negative amortization of principal, such as Option ARM loans, where the borrower can pay less than the interest owed on the loan, resulting in an increased principal balance during the life of the loan. The Company does not offer a subprime loan program (loans that generally target borrowers with weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios) or Alt-A loans (traditionally defined as loans having less than full documentation). Commercial Real Estate Loans - The Company originates and purchases commercial real estate loans. Commercial real estate loans are secured primarily by improved properties such as multi-family residential, retail facilities and office buildings, restaurants and other non-residential buildings. The maximum loan-to-value ratio for commercial real estate loans originated is generally 80%. Commercial real estate loans are generally written up to terms of five years with adjustable interest rates. The rates are generally tied to the prime rate and generally have a specified floor. Many of the fixed-rate commercial real estate loans are not fully amortizing and therefore require a balloon payment at maturity. The Company purchases from time to time commercial real estate loan participations primarily from outside the Company s market area. All participation loans are approved following a review to ensure that the loan satisfies the underwriting standards. Underwriting standards for commercial real estate loans include a determination of the applicant s credit history and an assessment of the applicant s ability to meet existing obligations and payments on the proposed loan. The income approach is primarily utilized to determine whether income generated from the applicant s business or real estate offered as collateral is adequate to repay the loan. There is an emphasis on the ratio of the property s projected net cash flow to the loan s debt service requirement (generally requiring a minimum ratio of 120%). In underwriting a loan, the value of the real estate offered as collateral in relation to the proposed loan amount is considered. Generally, the loan amount cannot be greater than 80% of the value of the real estate. Written appraisals are usually obtained from either licensed or certified appraisers on all commercial real estate loans in excess of $250,000. Creditworthiness of the applicant is assessed by reviewing a credit report, financial statements and tax returns of the applicant, as well as obtaining other public records regarding the applicant. 13
Loans secured by commercial real estate generally involve a greater degree of credit risk than one-to-four family residential mortgage loans and carry larger loan balances. This increased credit risk is a result of several factors, including the effects of general economic conditions on income producing properties and the successful operation or management of the properties securing the loans. Furthermore, the repayment of loans secured by commercial real estate is typically dependent upon the successful operation of the related business and real estate property. If the cash flows from the project are reduced, the borrower s ability to repay the loan may be impaired. Agricultural Real Estate Loans - The Company originates and purchases agricultural real estate loans. The maximum loan-to-value ratio for agricultural real estate loans we originate is generally 80%. Our agricultural real estate loans are generally written up to terms of five years with adjustable interest rates. The rates are generally tied to the average yield on U.S. Treasury securities, adjusted to a constant maturity of one year, three years, or five years and generally have a specified floor. Many of our fixed-rate agricultural real estate loans are not fully amortizing and therefore require a balloon payment at maturity. We purchase from time to time agricultural real estate loan participations primarily from other local institutions within our market area. All participation loans are approved following a review to ensure that the loan satisfies our underwriting standards. Underwriting standards for agricultural real estate include a determination of the applicant s credit history and an assessment of the applicant s ability to meet existing obligations and payments on the proposed loan. The income approach is primarily utilized to determine whether income generated from the applicant s farm operation or real estate offered as collateral is adequate to repay the loan. We emphasize the ratio of the property s projected cash flow to the loan s debt service requirement (generally requiring a minimum ratio of 120%). In underwriting a loan, we consider the value of the real estate offered as collateral in relation to the proposed loan amount. Generally, the loan amount cannot be greater than 80% of the value of the real estate. We usually obtain written appraisals from either licensed or certified appraisers on all agricultural real estate loans in excess of $250,000. We assess the creditworthiness of the applicant by reviewing a credit report, financial statements and tax returns of the applicant, as well as obtaining other public records regarding the applicant. Loans secured by agricultural real estate generally involve a greater degree of credit risk than one-to-four family residential mortgage loans and carry larger loan balances. This increased credit risk is a result of several factors, including the effects of general economic and market conditions on farm operations and the successful operation or management of the properties securing the loans. The repayment of loans secured by agricultural estate is typically dependent upon the successful operation of the farm and real estate property. If the cash flows are reduced, the borrower s ability to repay the loan may be impaired. Home Equity Loans The Company originates home equity loans and lines of credit, which are generally secured by the borrower s principal residence. The maximum amount of a home equity loan or line of credit is generally 95% of the appraised value of a borrower s real estate collateral less the amount of any existing mortgages or related liabilities. Home equity loans and lines of credit are approved with both fixed and adjustable interest rates which we determine based upon market conditions. Such loans may be fully amortized over the life of the loan or have a balloon feature. Generally, the maximum term for home equity loans is 10 years. Underwriting standards for home equity loans include a determination of the applicant s credit history and an assessment of the applicant s ability to meet existing obligations and payments on the proposed loan. The stability of the applicant s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income. We also consider the length of employment with the borrower s present employer as well as the amount of time the borrower has lived in the local area. Creditworthiness of the applicant is of primary consideration; however, the underwriting process also includes a comparison of the value of the collateral in relation to the proposed loan amount. 14
Home equity loans entail greater risks than one-to-four family residential mortgage loans, which are secured by first lien mortgages. Collateral repossessed after a default may not provide an adequate source of repayment of the outstanding loan balance because of damage or depreciation in the value of the property or loss of equity to the first lien position. Further, home equity loan payments are dependent on the borrower s continuing financial stability, and therefore are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Finally, the application of various Federal and state laws, including Federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans in the event of a default. Commercial Business Loans - The Company originates commercial business loans to borrowers located in the Company s market area which are secured by collateral other than real estate or which can be unsecured. Commercial business loan participations are also purchased from other lenders, which may be made to borrowers outside the Company s market area. Commercial business loans are generally secured by equipment and inventory and generally are offered with adjustable rates tied to the prime rate or the average yield on U.S. Treasury securities, adjusted to a constant maturity of either one year, three years or five years and various terms of maturity generally from three years to five years. Unsecured business loans are originated on a limited basis in those instances where the applicant s financial strength and creditworthiness has been established. Commercial business loans generally bear higher interest rates than residential loans, but they also may involve a higher risk of default since their repayment is generally dependent on the successful operation of the borrower s business. Personal guarantees are generally obtained from the borrower or a third party as a condition to originating its business loans. Underwriting standards for commercial and agricultural business loans include a determination of the applicant s ability to meet existing obligations and payments on the proposed loan from normal cash flows generated in the applicant s business. The financial strength of each applicant is assessed through the review of financial statements and tax returns provided by the applicant. The creditworthiness of an applicant is derived from a review of credit reports as well as a search of public records. Business loans are periodically reviewed following origination. Financial statements are requested at least annually and review them for substantial deviations or changes that might affect repayment of the loan. Loan officers also visit the premises of borrowers to observe the business premises, facilities, and personnel and to inspect the pledged collateral. Underwriting standards for business loans are different for each type of loan depending on the financial strength of the applicant and the value of collateral offered as security. Agricultural Business Loans - The Company originates agricultural business loans to borrowers located in our market area which are secured by collateral other than real estate or which can be unsecured. Agricultural business loans are generally secured by equipment and blanket security agreements on all farm assets. These loans are generally offered with fixed rates with terms up to five years. Agricultural business loans generally bear lower interest rates than residential loans due to competitive market pressures. The repayment of agricultural business loans is generally dependent on the successful operation of the farm operation. Personal guarantees are generally obtained from the borrower as a condition to originating agricultural business loans. Underwriting standards for agricultural business loans include a determination of the applicant s ability to meet existing obligations and payments on the proposed loan from normal cash flows generated in the applicant s business. The financial strength of each applicant is assessed through the review of financial statements, pro-forma cash flow statements, and tax returns provided by the applicant. The creditworthiness of an applicant is derived from a review of credit reports as well as a search of public records. Financial statements are requested at least annually and reviewed for substantial deviations or changes that might affect repayment of the loan. Loan officers may also visit the premises of borrowers to observe the operation, facilities, equipment, and personnel and to inspect the pledged collateral. Underwriting standards for agricultural business loans are different for each type of loan depending on the financial strength of the applicant and the value of collateral offered as security. 15
The repayment of agricultural business loans generally is dependent on the successful operation of a farm and can be adversely affected by fluctuations in crop prices, increase in interest rates, and changes in weather conditions. These developments may result in smaller harvests and less income for farmers which may adversely affect such borrower s ability to repay a loan, and potentially result in an increase in the level of problem loans and loan losses in our agricultural portfolio. While not required, the majority of our agricultural business loans are covered by crop insurance, which provides protection against loss due to lower crop yields as a result of unfavorable weather conditions. Consumer Loans The Company originates consumer loans, including automobile loans, loans secured by deposit accounts, unsecured loans and mobile home loans. Consumer loans are generally offered on a fixed-rate basis. Automobile loans are offered with maturities of up to 60 months for new automobiles. Loans secured by used automobiles will have maximum terms which vary depending upon the age of the automobile. Automobile loans are generally originated with a loan-to-value ratio below the greater of 80% of the purchase price or 100% of NADA loan value. In the case of a new car loan, the loan-to-value ratio may be greater or less depending on the borrower s credit history, debt to income ratio, home ownership and other banking relationships with us. Underwriting standards for consumer loans include a determination of the applicant s credit history and an assessment of the applicant s ability to meet existing obligations and payments on the proposed loan. The stability of the applicant s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income. We also consider the length of employment with the borrower s present employer as well as the amount of time the borrower has lived in the local area. Creditworthiness of the applicant is of primary consideration; however, the underwriting process also includes a comparison of the value of the collateral in relation to the proposed loan amount. Consumer loans entail greater risks than one-to-four family residential mortgage loans, particularly consumer loans secured by rapidly depreciating assets such as automobiles or loans that are unsecured. In such cases, collateral repossessed after a default may not provide an adequate source of repayment of the outstanding loan balance because of damage, loss or depreciation. Further, consumer loan payments are dependent on the borrower s continuing financial stability, and therefore are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Such events would increase our risk of loss on unsecured loans. Finally, the application of various Federal and state laws, including Federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans in the event of a default. 16
The following tables present the balance in the allowance for loan losses and the recorded investment in loans based on portfolio segment and impairment method as of and for the periods ended June 30, 2016, June 30, 2015, and December 31, 2015. June 30, 2016 Commercial Agricultural 1-4 Family Real Estate Real Estate Home Equity Commercial Agricultural Consumer Unallocated Total Allowance for Loan Losses: Beginning Balance, April 1, 2016 $ 864,863 $ 900,422 $ 202,004 $ 201,537 $ 345,975 $ 160,370 $ 161,474 $ 98,046 $ 2,934,691 Provision charged to expense (27,142) 10,337 3,629 (4,161) 26,196 2,293 19,485 (637) 30,000 Losses charged off (6,414) - - - - - (11,899) - (18,313) Recoveries 5,205 2,971-525 116-3,370-12,187 Ending balance, June 30, 2016 $ 836,512 $ 913,730 $ 205,633 $ 197,901 $ 372,287 $ 162,663 $ 172,430 $ 97,409 $ 2,958,565 Beginning Balance, January 1, 2016 $ 829,604 $ 917,526 $ 201,918 $ 149,253 $ 386,620 $ 163,346 $ 169,381 $ 101,946 $ 2,919,594 Provision charged to expense 24,501 (6,796) 3,715 47,598 (14,449) (683) 10,651 (4,537) 60,000 Losses charged off (26,879) - - - - - (11,899) - (38,778) Recoveries 9,286 3,000-1,050 116-4,297-17,749 Ending balance, June 30, 2016 $ 836,512 $ 913,730 $ 205,633 $ 197,901 $ 372,287 $ 162,663 $ 172,430 $ 97,409 $ 2,958,565 Ending balance: individually evaluated for impairment $ 240,962 $ 523,618 $ - $ 9,561 $ 111,625 $ - $ - $ - $ 885,766 Ending balance: collectively evaluated for impairment $ 595,550 $ 390,112 $ 205,633 $ 188,340 $ 260,662 $ 162,663 $ 172,430 $ 97,409 $ 2,072,799 Loans: Ending balance $45,994,916 $40,409,491 $41,126,629 $ 11,203,055 $25,747,471 $13,424,032 $14,021,513 $ - $191,927,107 Ending balance: individually evaluated for impairment $ 638,345 $ 1,408,875 $ - $ 61,786 $ 256,547 $ - $ - $ - $ 2,365,553 Ending balance: collectively evaluated for impairment $45,356,571 $39,000,616 $41,126,629 $ 11,141,269 $25,490,924 $13,424,032 $14,021,513 $ - $189,561,554 17